Recession risk unless oil prices fall further

If history is any guide, another oil-induced recession may be just around the corner, at least for the United States and some of the other developed economies.

Every time that the cost of oil relative to global economic output has hit current levels -- and that's even after sharp falls in spot prices this month -- it has heralded a slump.

And while economists and analysts say a serious slowdown can still be avoided, many add that unless oil and energy prices fall much further and -- most important -- stay down, the world economy could be in serious trouble.

"We are in a danger area for the world economy," said Christophe Barret, global oil analyst at Credit Agricole.

The warning signal flashing is what economists call the "oil expense indicator": the share of oil expenses as a proportion of worldwide gross domestic product (GDP) (oil prices times oil consumption divided by world GDP).

Since 1965, this has averaged roughly 3 percent of GDP, and it has only exceeded 4.5 percent during three periods: in 1974, between 1979 and 1985 and in 2008.

Each period has seen severe global recessions.

In 1973/74, during the first global "oil shock", oil prices rocketed after an Arab oil embargo in response to an Arab-Israeli war disrupted oil flows and triggered panic buying.

In 1979, revolution in Iran knocked out much of the country's oil output and was followed by a long Iran-Iraq war, bringing a second "oil shock".

In 2008, propelled by a housing bubble, speculative buying of new debt instruments and a commodities boom, oil prices exceeded $100 per barrel for the first time and soared to a record high above $147, helping trigger financial crisis and the worst slump since World War II.

"DRAG"

This time, oil prices have soared following the loss of around 1.6 million barrels per day (bpd) of Libyan oil, uprisings across the Middle East and North Africa and rapid economic growth in China, India and other developing economies.

Using the oil expense indicator, economists say Brent crude, the international oil benchmark, would need to be in the low $90s per barrel to be under the 4.5 percent danger mark.

In fact, Brent hit a two-and-a-half-year high of more than $127 per barrel in April and, with the exception of an intra-day dip on Tuesday, has been over $100 for six months.

Even after a fall of more than $20 from its early-August high on worries over a slowdown in the developed economies, Brent is still not far off $110 per barrel.

Oil is a key global cost because it is crucial to every part of the economy, powering manufacturing and the production of food and other commodities, fuelling transport as well as being a building block for industries such as plastics and electronics.

If it is too high for too long, the results are dramatic.

"The last two times that energy as a share of global GDP neared ... the current level, the world economy experienced severe crises: the double dip recession of the 1980s and the Great Recession of 2008," Merrill Lynch analysts led by Francisco Blanch said in a note to clients.

Economists reinforce their warnings over the possibility of an impending slowdown with data showing that oil demand has begun to shrink in some countries in response to high prices.

LEADING INDICATOR

Oil data lags, but the latest U.S. figures, for May, show a drop of 4.7 percent year-on-year in U.S. gasoline demand.

Deutsche Bank analyst Adam Sieminski says he is concerned by a trend towards lower U.S. oil demand evident since last summer:

"The last time U.S. oil demand was falling was in 2007 and early 2008," Sieminski said in a note written with analyst Michael Lewis. "This was a leading indicator of the economic troubles that would hit the U.S. in the middle of 2008."

Analysts differ on exactly how high oil prices need to be and how long they need to stay up before they slow growth. Some economists argue the impact of oil prices has been exaggerated, and others note that not all recessions are caused by oil, such as slowdowns in the early 1990s and again a decade later.

But most economists argue there is a level at which fuel input costs become incompatible with continuing economic growth.

James Zhang, an analyst at Standard Bank, says the danger level comes with the oil expense indicator at around 5 percent:

"$100 per barrel represents about 5 percent for the 'oil expense indicator', which we think would be a threshold on an annual average level to potentially kill off global growth," he said.

"Absent any shocks, I don't believe an oil price, say in the range of $100 to $130, will necessary bring a recession itself, but a slower growth is almost ensured -- another sharp jump in oil prices could act as a shock," Zhang said.

Barret said record high oil and commodity prices were putting unsustainable pressure on household expenditure, and while he like other economists is reluctant to predict recession, he thinks the warnings should be heeded:

"There is still a chance that oil prices will go down very significantly, and that could be a strong support to the economy. But if prices stay near $110 per barrel until the end of the year, we will have a major problem by the start of 2012,

"He said.”We either get sharply lower prices or a recession that will bring down prices. Either way, oil prices must come down."

Credit: REUTERS